Paul Krugman writes:
Robert Rubin is wrong about the dollar: He says: “You could have had [budget] surpluses that affected the savings rate and would have helped the trade balance. I think you would have had more confidence in the policy framework and you would have had a [stronger] dollar.”...
This is what John Williamson of the Institute for International Economics calls “the doctrine of immaculate transfer.”... Here’s a (somewhat) plainer English version:
The problem becomes apparent if one asks how a higher savings rate translates into a smaller trade deficit. It is not enough to insist that the accounting ensures that it must. A consumer deciding between a Ford and a Honda cares nothing about the US’s national income accounts. How does a lower US budget deficit persuade Americans to buy fewer foreign goods and foreigners to buy more US products?...
The chain of events would look something like this: a fall in the budget deficit reduces demand in the US economy; to avoid a recession, the Federal Reserve lowers interest rates; as a result, the dollar falls; this lower dollar makes US goods cheaper compared with foreign substitutes, causing the necessary switch in expenditure.... [I]t is naive to imagine that changes in the government’s financial balance can translate directly into changes in physical trade flows, without working through a mechanism such as the exchange rate. That is the fallacy of ‘immaculate transfer’ - confusing the accounting principle which says that the current account balance equals the savings-investment balance with the process that enforces that constraint on decision-makers...
And apparently the old fallacy continues to hold sway.
I think that Rubin is implicitly working in a different model than the NIPA-based monetarist workhorse that Krugman (and I!) instinctively reach for first. I think that in Rubin's mind the chain of causation looks something like this:
- A government establishes a sane, balanced long-run fiscal policy.
- Businesses conclude that the country is a safe one in which to invest to build export capacity: since they do not fear future random and confiscatory taxation or inflation, factories making internationally-traded goods that would have been built abroad are built here at home instead.
- With more export capacity at home and less abroad, exports rise and imports shrink at the current exchange rate.
- Supply and demand leads the domestic currency to appreciate in order to balance trade.
Rubin's channel is: good fiscal policy --> expanded export supply --> export surplus --> higher currency value.
By contrast, Krugman's channel is: good fiscal policy --> lower domestic interest rates --> reduced currency value --> export surplus.
Which side am I on? I tell my undergraduates:
At a time horizon of 0-3 years, be a Keynesian: the most important things are the fluctuations in unemployment, in real demand, and in capacity utilization.
At a time horizon of 3-8 years, be a demand-side monetarist: you can assume (provisionally) that fluctuations in employment, real demand, and capacity utilization die out; the most important things are the fluctuations in the composition of real demand (investment vs. consumption vs. government vs. net exports) and in inflation- and deflation-causing nominal demand assuming (provisionally) stable growth of the economy's productive capacity.
At a time horizon of 8 years or greater, be a sane supply-sider: the most important things are the processes of investment in physical, human, and organizational capital that raise the economy's productive capacity.
Thus I was happy telling my undergraduates in 1985 that the reason the dollar was strong was because of the five years of Reagan deficits--high domestic interest rates, you see, pushing up the value of the dollar (and raising the trade deficit). And I was happy in 1992 telling my undergraduates that the reason the dollar was weak was because of the twelve years of Reagan-Bush deficits--large budget deficits starving the economy of capital that made us less productive than in some counterfactual in which we had elected some Eisenhower Republican in 1981.
And so today I call this one for Paul Krugman: we are only in year six of the Bush II derangement of American fiscal policy, and so I think the dollar is a little higher than it would be if the U.S. budget deficit were lower. But in two years I may have a different answer.